Correlation Risk and the Term Structureof Interest Rates

We develop a new completely affine model of the term structure of interest rates, in which the statevariables evolve as a matrix-valued process of stochastically correlated factors. This setting grants a newelement of flexibility in the simultaneous modeling of stochastic volatilities and correlations of factors,and in the formulation of the market price of risk. We demonstrate that already its most parsimoniousthree-factor specification provides a unified answer across a set of empirical regularities such as (i) thepredictability of excess bond returns, (ii) the persistence of conditional volatilities and correlations ofyields, or (iii) the hump in the term structure of forward rate volatilities and implied volatilities ofcaps.[...]